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Treasury Department issues insurance tax reports.

In March the Treasury Department issued a report covering the effect on U.S. reinsurance corporations of the waiver by treaty of the excise tax imposed on certain reinsurance premiums, and another on the taxation of life insurance company products. Both reports were mandated by Congress to provide data for possible legislation.

The purpose of the excise tax report was to determine whether U.S. reinsurance corporations were placed at a competitive disadvantage regarding foreign reinsurers because of treaties between the United States and certain foreign countries. Such treaties exempt the residents of those countries from the 1 percent excise tax on reinsurance premiums paid to foreign insurers which reside in those countries. In addition, the report considers whether the rate of excise tax on reinsurance premiums should be increased from 1 percent to 4 percent.

Generally, under the Internal Revenue Code, if an insurer or reinsurer is a U.S. or foreign corporation engaged in trade or business within the United States, its underwriting and investment income is taxable on a net basis at graduated rates. The U.S. corporation is taxed on its worldwide income; the foreign corporation is taxed on income "effectively connected" with its U.S. trade or business. Foreign corporations that insure and reinsure U.S. risks but are not engaged in such business in the United States pay an excise tax imposed on premiums paid regarding such risks. The rate is 1 percent on reinsurance and 4 percent on direct insurance. Some French, British and West German tax treaties include a waiver of insurance premiums and excise taxes paid to insurers and reinsurers.

In 1986 amendments to the code increased the tax that insurance companies subject to income tax must pay by requiring them to discount their loss reserves in calculating taxable income. Some U.S. reinsurers complained that a 1 percent excise tax on reinsurance premiums was too low in view of the discounting rules, and that it placed U.S. reinsurers at a competitive disadvantage. The Treasury Department subsequently came to the following conclusions:

"With respect to foreign companies resident in full tax jurisdictions (i.e., those that impose a material level of tax on insurance income), there is no evidence that waiving the one percent excise tax on reinsurance premiums creates a material competitive advantage for foreign reinsurers. However, because there is significant tax imposed in the foreign country, and the U.S. excise tax generally is not creditable in the other country to reduce that country's taxes imposed on the same income, the U.S. companies would generally have a significant advantage if the excise tax were increased from one percent to four percent and not waived by treaty.

"With respect to foreign companies resident in no tax jurisdictions (for example, Bermuda, Barbados and Cayman), there is evidence that waiving the excise tax generally increases the competitive advantage of the foreign companies. To the extent the foreign company is owned by U.S. persons taxable under Subpart F (i.e., the controlled foreign corporation provisions), however, waiving the excise tax by treaty does not generally create or increase a competitive advantage for the foreign company." (It appears that this conclusion is inconsistent with the removal of excise tax exemptions from the Bermuda and Barbados treaties.)

"If Congress chooses to increase the excise tax on reinsurance premiums, consideration should be given to making the tax creditable to U.S. shareholders taxable under Subpart F."

In Bermuda, Barbados, Cayman and other "no tax" jurisdictions such a provision would eliminate the excise tax if the shareholders of the foreign insurers or reinsurers were subject to taxation under Subpart F (the controlled foreign corporation).

Life Insurance

The report on life insurance products was requested by Congress to determine the effect of changes to the code. In 1982 Congress altered the way in which early distributions from annuity contracts were taxed so that such distributions were first taxed as ordinary income and, in some cases, a penalty was imposed. In 1984 the tax policies of certain investment-oriented life insurance contracts were modified.

In 1986 Congress attempted to regulate the ability of corporations to use life insurance by limiting the amount of interest deductible on policy loans. The ability to defer the tax on the investment income earned on corporate-owned annuities was also restricted.

In 1988 Congress amended the rules governing distributions prior to the death of the insured regarding certain investment-oriented life insurance contracts. This legislation also required the Treasury Department to conduct a study of the effectiveness of these revisions to the tax treatment of life insurance and annuity products in hopes of preventing the sale of such products primarily for investment purposes.

The report found that the law still provides favorable tax treatment of investment income (inside buildup) earned on qualified life insurance contracts and annuities. Although investment income on such products distributed prior to the death of the insured is tax-deferred, investment income earned on such contracts held until death is permanently exempt from federal tax. Investment income earned on annuities is treated less favorably but also benefits from tax deferral without the annual contribution or income limitations generally applicable to other tax-favored retirement vehicles.

The report also found that legislation enacted during the 1980s has tightened the tax rules for investment-oriented life insurance products and early distributions from annuity contracts, and has been somewhat effective. For example, the sale of single premium life insurance contracts fell after the 1988 tax changes. However, the 1986 restrictions on corporate-owned life insurance have not been effective.

In addition, life insurance annuity contracts provide unlimited tax saving opportunities compared to qualified retirement savings plans that have annual contribution and income limitations as well as antidiscrimination rules.

Finally, the principal justification of the current treatment of life insurance annuity products is to encourage the financial support of dependents after the death of a wage-earner, allow protection against "outliving" one's assets and encourage private long-term savings. The report questions whether this favorable treatment on inside buildup is the most effective way of achieving these goals. The current tax treatment of life insurance annuity products promotes use of such products to maximize the tax benefits from investment-oriented products. As a result, there is encouraged investment in case value life insurance products as opposed to a purchase of term life insurance and savings through financial institutions other than insurance companies. Investors use life insurance and annuity contracts to avoid limitations in other retirement savings vehicles. Also, revenue loss arises from tax arbitrage by corporations borrowing against corporate-owned life insurance, and favorable tax treatment of pre-death distributions on life insurance contracts reduces the amount of long-term savings and family protection provided through cash value life insurance.

The policy options recommended to Congress include disallowing the deduction of interest on loans secured by corporate-owned life insurance, eliminating the tax-advantaged treatment of non-qualified annuities without significant life contingencies and tightening the taxation of certain distributions from life insurance contracts to conform to the deferred annuity rules.

P. Bruce Wright is a member of the New York Bar. Mr. Wright is also a member of the law firm LeBoeuf, Lamb, Leiby and MacRae.
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Author:Wright, P. Bruce
Publication:Risk Management
Article Type:column
Date:Jun 1, 1990
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